Ideas and discussions about economic and financial literacy issues.
Named one of the 100 best blogs for econ students by Online Universities Weblog.

Tuesday, July 29, 2008

Price Affects Behavior

A couple of articles in today's issue of The Wall Street Journal could be easily used to help students understand how price affects behavior. Both of them are worth looking at if you're looking for current issues to illustrate your discussion.

The first article is about the decision facing the town of Plymouth, Mass. As a method of dealing with increasingly high volumes of trash, Plymouth has decided to follow the lead of other cities and adopted a "pay as you throw" (PAYT) system. In it, residents pay a basic monthly fee (lower than it was in the past). Items that can be recycled are placed in separate containers and picked up "free" - we know there's no such thing as a free lunch...or free trash. All other items must be placed in special plastic bags that cost $1.25 each. The concept is economically sound. Those who generate the greatest volume of trash (non-recyclable) will pay the most.

Many residents have embraced the idea. Many are against it. And your students may be able to predict how behavior changes. According to the article, 20% of the communities that have adopted PAYT have experienced illegal dumping. Likewise people, acting rationally, try to cram more trash into each bag. And while the article doesn't mention it, I suspect there's an increase in the amount of non-recyclable material in the recycling bins.

The reaction, while predictable is interesting. In most communities, citizens pay for trash removal, just not directly. The costs of the service are "hidden." And in many cases, the cost may not bear a relationship to the volume of trash generate. For many people, trash removal is a public service. But can it also be seen as an externality - a benefit or cost shared by people outside of a transaction? Here's what I'm suggesting. In systems where there is little or no direct relationship between volume and price, those who generate large volumes may be paying less than their share, thus receiving a benefit they don't pay for - a positive externality. Those who generate less may end up paying more than their rightful share - paying for a benefit they don't receive - a negative externality. Does adopting PAYT minimize exteranalities and allow for costs more accurately assessed? Who knows, a positive consequence out of this may be an increased outcry about packaging.

Now, let's take a look at the second story. This one concerns power blackouts in Indonesia, a nation that is a major coal producer and that generates much of its electricity using coal. This may seem odd, but the story gets more interesting. Indonesia's coal producers, like many coal producers elsewhere, can sell their coal domestically or to the foreign market. Now, your students may wonder "Who cares? What difference does it make?" Enter the price mechanism. In Indonesia, coal sold to the domestic state-owned power company is sold at a controlled price. This is done to control the price of electricity for consumers, either businesses or homes. However, with the worldwide energy situation, the price of coal for foreign consumption has risen. This means more profit for the producers, giving them the ability and incentive to find and produce more coal.

Again, because of an existing price structure, people are not bearing the full cost of their use. Government is subsidizing the use, while at the same time asking people to reduce consumption - something they have no real incentive to do, given the price. This is an artificial price constraint. And the artificially low price encourages consumption. If the domestic price controls are extended to exports, through a tax of some kind, for example, they may actually discourage production. The incentive of an artificially low price is to reduce production and encourage consumption, which leads to shortages.

If the Indonesian government were to move to a domestic energy price that more closely reflected actual costs, there would undoubtedly be political unrest. But I hardly think repeated blackouts such as they are currently experiencing will be a viable alternative.

These both provide good examples of mind exercises to use with your students. And at the same time, they will provide some discussion about government in the economy. I look forward to your comments.

2 comments:

Great articles Tim and valuable for classroom discussion. These examples are clear and will illustrate effectively several key economic concepts. You are becoming an economics teacher's most valuable support.

Blog Archive Note

All entries prior to August 15, 2007 appeared on the economic education blog of the Federal Reserve Bank of Chicago. Entries between August 15, 2007 and July 31, 2009 were under the auspices of the Powell Center for Economic Literacy in Richmond, VA.